New research shows how companies game the system to boost CEO pay

A rule designed to make executive compensation more transparent has instead given companies a tool to push CEO pay even higher, according to an analysis by researchers at UC Berkeley’s Haas School of Business and Columbia University.

Since 2006, the Securities and Exchange Commission has required public companies to name a group of peer companies that they use to benchmark their chief executives’ salaries, giving investors and the public a reference point to judge whether CEO paychecks are within reason. But while benchmarking is a good idea in theory—applauded by corporate governance experts—in practice companies tend to cherry-pick peers with highly paid CEOs, says Berkeley Haas Asst. Prof. Mathijs De Vaan.

“We found strong evidence that the benchmarking process has been systematically gamed,” says De Vaan, an economist in the Haas Management of Organizations Group. “Peer groups are assembled more to legitimize excessive pay than to provide objective information about an appropriate level of compensation.”

Dramatic rise in CEO pay

Mathijs De Vaan

The dramatic rise in executive pay in recent years is fueling the growing income inequality that has become a first-order public policy issue, economists have found. Average CEO compensation jumped 12% per year from 1980 to 2004, swelling from $625,000 to $9,840,000. And while the median market capitalization for companies in the S&P 1500 grew just 22% from 2007 to 2014, median CEO compensation grew 39%, according to the paper. To allow for more public scrutiny of CEO pay, the SEC began requiring companies to disclose what peer companies pay their chief executives.

Skewed peer groups

Since then, a number of researchers have looked into whether this executive compensation benchmarking process is fair and unbiased, but measuring it has proved tricky. De Vaan and his coauthors came up with a novel way of determining whether compensation benchmarks were skewed toward higher salaries. Using data from more than 3,400 companies that reported compensation peer groups to the SEC between 2006 through 2016, they developed a model to generate alternative benchmark​ groups that were free from bias. They did this by creating reciprocal groups of peers—that is, if company A compared its CEO’s pay with that of company B, company B would also ​benchmark against company A. They used the model to simulate hundreds of alternative peer groups, and then compared these with the benchmark​ groups​ companies actually used.

The results strongly suggest that companies typically chose a skewed sample of highly paid CEOs. Not only that, but these skewed peer groups were closely associated with real increases in CEO compensation. In other words, benchmarking was used to justify high pay, and CEOs benchmarked against highly paid peers were paid substantially more, they concluded.

Underperformers get bigger rewards

In fact, the researchers found that benchmarking is even more skewed when CEOs fail to meet their performance targets, such as stock market value and profit. De Vaan and his coauthors found new evidence that these underperforming CEOs get especially generous pay packages. The researchers’ statistical analysis showed that decreases in returns on assets—a standard profitability measure—were associated with wider gaps between the selected peer group and the simulated peer groups created by the researchers.

“If you’re a CEO who doesn’t perform well, your compensation should be adjusted downward,” De Vaan says. “One way companies prevent that is by introducing more bias.”

The authors also found that companies that had greater discretion in choosing peer firms, perhaps because they didn’t fit neatly into an industry category, tended to use that flexibility to select peer groups with even higher-paid executives.

Finally, De Vaan and his coauthors looked at how peer-group benchmarking has changed over time. They found that the average level of bias has diminished, which may reflect growing shareholder and regulatory pressure on companies to avoid abusing the disclosure process. However, the association between peer group bias and executive pay has increased over time, meaning that CEOs get greater financial gains from skewed benchmarking now than they did in the past.

A role for watchdogs

Why don’t boards push back? The researchers point out that board members may want to maintain cordial relationships with their CEOs, and also that they tend to be executives themselves, and may be inherently biased toward increasing executive pay.

Although the authors did not explore the indirect effects of peer-group benchmarking, De Vaan thinks it’s probable that biased benchmarking by some companies may also affect firms that aim to select an unbiased set of peers. When a company skews its peer group to push up its own CEO’s pay, that in turn becomes a potential reference for other companies. “Given the network nature of this process, it is difficult to be honest,” he says.

Is there a way to stop the merry-go-round? De Vaan thinks probably not, as long as companies select their own peer groups for benchmarking. But the story would be different if industry watchdogs or regulators created unbiased peer groups for companies that were similar in size and business mix. That would allow benchmarking to do what it is supposed to do—give shareholders an objective way of evaluating whether CEOs deserve their pay.